Chapter 1

Book Chapter 1 - An Overview of Bank and their service

Q: What is a bank? How does a bank differ from most other financial-service providers?

A bank is a financial institution and a financial intermediary that accepts deposits and channels those
deposits into lending activities, either directly or through capital markets. A bank connects customers
that have capital deficits to customers with capital surpluses.

Other financial service providers offer some of the financial services offered by a bank, but not all of
them within one institution.

Q: Why are some banks reaching out to become one-stop financial-service conglomerates? Is this a
good idea, in your opinion?

There are two reasons that banks are increasingly becoming one-stop financial service conglomerates.

1. the increased competition from other types of financial institutions and the erosion of banks’
traditional service areas.
2. 2.the Financial Services Modernization Act which has allowed banks to expand their role to be
full-service providers.

Q: What is a merchant banking service?

Merchant banking is a professional service provided by the merchant banks to their customers
considering their financial needs, for adequate consideration in the form of fee. Merchant banks are
banks that conduct fundraising, financial advising and loan services to large corporations.

Q: What different kinds of services do banks offer the public today? What services do their closest
competitors offer?

Different kinds of services do banks offer the public today:

1. Taking deposits

2. Extending loans to individuals and businesses.

3. Cashing cheque

4. Facilitating money transactions such as wire transfers and cashier's checks

5. Issuing credit cards, ATM cards, and debit cards

6. Storing valuables, particularly in a safe deposit box

7. Consumer & commercial financial advisory services

8. Pension & retirement planning

All of these services are also offered by their closest competitors. Banks and their closest competitors
are converging and becoming the financial department stores of the modern.

Q: Why do banks exist in modern society. according to the theory of finance?

There are multiple approaches to answering this question. The traditional view of banks as financial
intermediaries sees them as simultaneously fulfilling the financial-service needs of savers (surplus-
spending units) and borrowers (deficit-spending units), providing both a supply of credit and a supply of
liquid assets.

A newer view sees banks as delegated monitors who assess and evaluate borrowers on behalf of their
depositors and earn fees for supplying monitoring services.

Banks also have been viewed in recent theory as suppliers of liquidity and transactions services that
reduce costs for their customers and, through diversification, reduce risk. Banks are also critical in the
payment system for goods and services and have played an increasingly important role as a guarantor
and a risk management role for customers.

Q: Can you explain why many of these changes have led to significant problems for the management
of banks and other financial firms and for their stock-holders?

The net result of recent changes in banking and the financial services market has been to put greater
pressure upon their earnings, resulting in more volatile returns to stockholders and an increased bank
failure rates. Some experts see banks role and market share shrinking due to restrictive government
regulations and intensifying competition. Institutions have also become more innovative in their service
offerings and in finding new sources of funding, such as off balance-sheet transactions. The increased
risk faced by institutions today, therefore, has forced managers to more aggressively utilize a wide array
of tools and techniques to improve and stabilize their earnings streams and manage the various risks
they face.
 Book Chapter 4 (The Financial Statement of a Bank)
Q: What are the principal accounts that appear on a bank’s balance sheet (Report of Condition)?

Ans: The Balance Sheet of a Bank Showing its Assets, Liabilities and Net Worth (equity capital) at a given
point in time.May be viewed as a list of financial inputs (sources of funds) and outputs (uses of funds)

Assets =Liabilities +Equity Capital

C + S + L + MA = D + NDB + CA

C = Cash Assets

S = Security Holdings

L = Loans

MA = Miscellaneous Assets

D = Deposits

NDB = Nondeposit Borrowings

CA = Capital Accounts

Financial Outputs Financial Inputs

(use of bank funds) (sources of bank funds or liabilities)

Cash Assets [C] Deposits from the Public [D]

Cash in vault/ reserve requirement with Central bank & Retail or corporate deposit, interbank deposit
deposits with other depository institutions

Investment in Securities [S] Nondeposit Borrowings [NDB]

Money market instrument such as T-bills, commercial Discount loans (loans from Fed), loans from holding
paper companies or other banks

Loans & Leases [L] Equity Capital [EC]

Miscellaneous Assets [MA]

Fixed assets such as branch network, computers,

premises
Q: Which accounts are most important and which are least important on the asset side of a bank’s
balance sheet?

Ans: The rank order of assets by dollar volume appearing on U.S. bank balance sheets are as follows:

Rank Order Assets:

1. Loans
2. Investment Securities
3. Cash
4. Miscellaneous Assets

Q: What accounts are most important on the liability side of a balance sheet?

The principal bank liability items from most important to least important are:

Rank Order Liabilities and Equity Capital:

1. Deposits
2. Non deposit Borrowings
3. Equity Capital
4. Miscellaneous Liabilities.

Q: In rank order, what are the most important revenue and expense items on a Report of Income?

By dollar volume in most recent years the rank order of the revenue and expense items on a bank's
Report of Income is:

Rank Order Revenue Items:

1. Loan Income
2. Security Income
3. Service Charges on Deposits and Other Deposit Fees
4. Other Operating Revenues

Rank Order Expense Items:

1. Deposit Interest.
2. Interest on Non deposit Borrowings.
3. Salaries, Wages, and Employee Benefits
4. Miscellaneous Expenses
Q: What are off-balance-sheet items, and why are they important to some financial firms?

Banks have converted many of their customers in recent years into fee-generating transactions that are
not recorded on their balance sheet.

• Standby Credit Agreements (bank pledges to guarantee repayment of a customer’s loan received
from a third party)
• Interest Rate Swaps (bank promises to exchange interest payment on debt securities with another
party)
• Financial Futures & option Interest-rate Contracts (bank agrees to deliver or to take delivery of
securities from another party at a guaranteed price)
• Loan Commitments (bank pledges to lend up to a certain amount of funds until the commitment
matures)
• Foreign exchange Rate Contracts (bank agrees to deliver or accept delivery of foreign currencies)

They are important as a supplement to income from loans and to help a bank reduce its exposure to
interest-rate risk.

Q: What are primary and secondary reserves and what are they supposed to do?

Primary reserves consist of cash, including a bank's vault cash and checkable deposits held with other
banks or any other funds that are accessible immediately to meet demands for liquidity made against
the bank.

Secondary reserves consist of assets that pay some interest (though usually pay returns that are much
lower than earned on other assets, such as loans) but their principal feature is ready marketability. Both
primary and secondary reserves are held to keep the bank in readiness to meet demands for cash
(liquidity) from whatever source those demands may arise.

Q: What is interest income?

Earnings generated by investments such as savings accounts and certificates of deposit are referred to
as interest income. For financial companies, revenue minus expenses is referred to as net interest
income.

Q: What is interest expenses?

Interest expense is the cost of borrowed funds. It is reported on the income statement as a non-
operating expense, and is derived from such lending arrangements as lines of credit, loans, and bonds.
Interest expense is usually a tax-deductible expense, which makes debt a lower-cost form of funding
than equity.

Q: What is the Non-interest income?

Sources of income other than interest revenues from loans and investments are called noninterest
income (or fee income).
Q: What are Non-interest expenses?

The key noninterest expense item for most financial institutions is wages, salaries, and employee
benefits, which has been an important expense item. The costs of maintaining a financial institution’s
properties and rental fees on office space show up in the premises and equipment expense. The cost of
furniture and equipment also appears under the noninterest expense category, along with numerous
small expense items such as legal fees, office supplies, and repair costs.

Q: Suppose that a bank holds cash in its vault of $1.4 million, short-term government securities of
$12.4 Concept Check million, privately issued money market instruments of $5.2 million, deposits at
the Federal Reserve banks of $20.1 million, cash items in the process of collection of $0.6 million, and
deposits placed with other banks of $16.4 million. How much in primary reserves does this bank hold?
In secondary reserves?

Q: What are the principal types of non-interest income received by bank? (box)

The breakdown includes:

• fees earned from fiduciary activities (such as trust services);

• service charges on deposit accounts;
• trading account gains and fees; and
• additional noninterest income (including revenues from investment banking,
security brokerage, and insurance services).

Recently financial service providers have focused intently on noninterest income as a key target for
future expansion.
Q: What is the relationship between the provision for loan losses on a bank’s Report of Income and
the allowance for loan losses on its Report of Condition?

Gross loans equal the total of all loans currently outstanding that are recorded on the bank's books. Net
loans are equal to gross loans less any interest income on loans already collected by the bank but not
yet earned and also less the allowance for loan-loss account (or bad-debt reserve). The allowance for
loan losses is built up gradually over time by an annual noncash expense item that is charged against the
bank's current income, known as the Provision for Loan Losses. The dollar amount of the annual loan-
loss provision plus the amount of recovered funds from any loans previously declared worthless
(charged off) less any loans charged off as worthless in the current period is added to the allowance-for-
loan-losses account. If current charge-offs of worthless loans exceed the annual loan-loss provision plus
any recoveries on previously charged-off loans the annual net figure becomes negative and is subtracted
from the allowance-for-loan-losses account.

Q: What types of information is provided in a fund flow or source and what uses of fund statement?

A bank's sources-and-uses-of-funds statement captures changes in its assets and liability items as well as
income from bank operations. It shows where the bank has raised its operating funds over a given
period of time and how those funds were allocated over that same time period. Generally, increases in
any liability item (such as deposits) represent a source of funds, while increases in any asset item are
uses of funds.

Q: What does the statement of stockholder equity reveal about how well a bank is being managed
and what stresses it is under ?

The Statement of Stockholders' Equity Capital reflects any changes that have occurred in a bank's equity
capital account. The most common items causing changes in a bank's equity capital account include the
proportion of current profits (net after-tax income) retained in the bank (which, if positive, increases
equity capital or, if negative, decreases equity) and changes in the number of shares of stock
outstanding. If more stock is sold, the equity capital account increases.